If You Can't Beat 'Em, Buy 'Em

Although a couple of deals does not necessarily make a trend, investors should get ready for a wave of M&A in the energy sector. We saw the Exxon Mobil (NYSE:XOM) - XTO Energy (NYSE:XTO) deal a few months ago, the deal between Arena Resources (NYSE:ARD) and SandRidge Energy (NYSE:SD)about a week ago and now the announced transaction between Haliburton (NYSE:HAL) and Boots & Coots (AMEX:WEL).

I believe these are just the first moves in a larger trend. With the credit and equity markets a little closer to normal, rising energy prices and increasing pressures on large energy company executives to "do something," merger and acquisition activity is going to look like an increasingly attractive option to many CEOs.

Drill Or BuyThe motivation for the E&P (exploration and production) companies is pretty simple - it has become increasingly difficult and increasingly expensive for companies to add reserves by sending geologists into the field, striking lease deals and sinking exploratory wells. More and more, fresh oil and gas fields are harder to reach and harder to exploit, whether for reasons of geology or geopolitics.

In the case of Exxon, for instance, they are paying XTO shareholders about $13.42 per barrel of oil equivalent (XTO is mostly a natural gas company). That compares to the roughly $10.00 per barrel that the company spent to add reserves in 2009, but the XTO deal is less risky than attempting to build reserves through the drillbit. That cost of reserve replacement has roughly doubled over the last six years, so Exxon is clearly banking on petroleum becoming both more difficult and more expensive to find, and many smaller rivals simply will not be able to keep up and may look to sell. (For more, see Oil And Gas Industry Primer.)

Go Big Or Go HomeOn the services side of the industry, the rationale for M&A is more about scale and global reach. As the energy companies go overseas to hunt for petroleum, they need the same sorts of services that they get over here in North America. Unfortunately, many E&P companies are forced to leave behind their preferred North American service providers when they go into foreign markets.

Global reach is not the only factor at play. The bigger you are as a service company, the more leverage you have - a large company like Transocean (NYSE:RIG) has a great deal more pull with shipyards and major energy companies when it comes to pricing new construction or existing rigs. Likewise, a company like Haliburton or Schlumberger (NYSE:SLB) has more leverage in terms of how it pays employees, amortizes its overhead, sources materials and prices its services than the smaller competitors do.

Who are the likely buyers? Any company with a lot of cash and a dearth of reserves (but especially a lot of cash) is a likely candidate. Petrochina (NYSE:PTR) has a $60 billion war chest earmarked for acquisitions, and companies like Chevron (NYSE:CVX) and BP (NYSE:BP) may feel the pressure to keep up.

M&A activity is often a mixed blessing for investors, as many companies have destroyed shareholder value by overpaying for, and then mismanaging, acquisitions. Still, in an environment of rising prices, rising costs and increasingly complexity, there are not a surplus of options.

Bottom LineNot all of these deals will be dogs, though. Exxon announced its deal for Mobil at the end of 1998, right before oil bottomed and then doubled in about a year. Whether or not natural gas doubles in the next year and XOM repeats that prescient timing with XTO, it is difficult to find anyone out there these days who does not believe that petroleum prices are heading inexorably higher until a real alternative is found. In the meantime, investors can still benefit from the trend as a wave of M&A would likely be a generally positive influence on valuations in small and mid-cap E&P and service companies. (For more, see Unearth Profits In Oil Exploration And Production.)